Stocks fell slightly Friday but still rose for the second straight week, something that hasn’t happened in months. Economic data was mixed with the big number being Friday’s employment report that showed once again that labor demand is still robust. Interest rates rose as fears of imminent recession receded. It is hard to declare we are in recession while adding 350,000-400,000 jobs every month.
July is going to be a busy month both for corporate and economic news. The aforementioned employment report was just the beginning. While the report was not particularly market moving for equities, it did reverse a slide in bond yields. Bond prices fell as fears evaporated that a slowdown in growth was melting into a full-fledged recession. When an economy begins to grow at a slower pace, it does so in an uneven manner. The downward pressure on growth comes from the efforts of central banks to dampen demand by raising rates and selling assets off their balance sheets. Interest sensitive industries, particularly housing, feel the pressure first. Homebuilders report a dramatic drop-off in traffic at new model homes, a function of higher mortgage rates and fears that prices will start to fall. Indeed, there is evidence in some parts of the country that prices are either stabilizing or moderating a bit. In some markets, buildings are giving incentives for the first time in almost two years. We have also seen from many retailers that while sales are still up year-over-year, all the increase comes from higher prices. In many cases, physical volumes are down. Even gasoline sales are falling, if measured by volume rather than price.
Not all parts of the economy are witnessing an erosion of demand. Go visit any airport. Despite airline delays and cancellations, people want to get out and travel after being cooped up for two years. Movie theaters are filling up as are concert venues. Americans are trading experiences for goods, spending more on the former and less on the latter. The switch shows up in the employment data as reported Friday.
I mentioned a lot of data to come in July. The next big number will be Wednesday morning’s release of the June Consumer Price Index (CPI). It is expected to be strong. The drop in gasoline prices that has occurred over the past 2-3 weeks won’t show up until the July data. I should note, however, that the CPI in June 2021 rose by 0.9% both before and after the impact of food and energy costs. That number drops away when comparing year-over-year. Thus, should the June reading this year show an increase of less than 0.9%, the year-over-year gain will actually decline from May. But, in any case, it is likely to be a disturbing number, a reminder that the Fed has a lot of work ahead of itself. The third major date of note is July 27th. That date marks the conclusion of the next 2-day FOMC meeting. A couple of weeks ago, when economic data appeared to be lagging, there were some calls to moderate the increase in interest rates from 75-basis points to 50, but Friday’s strong employment numbers nixed that. You can count on 75 again. The post-meeting question will be whether the next meeting in September sees a third increase of 75-basis points or not. Whatever the speculation is post-meeting, it will be just that, speculation. The answer in September will depend on how the economy reacts over the next two months.
We constantly hear economists discuss whether a soft landing or a recession lies in front of us. Certainly, despite the possibility that Q2 GDP fell slightly for the second quarter in a row (that number will be first reported on July 29), we are not in a recession if we are adding 350,000+ jobs every month. The Fed has made it clear that its laser focus today is to bring inflation back to a target close to 2%, and to make sure it stays anchored there. The latter is the hard part. Beating inflation down doesn’t require rocket science. Raise interest rates enough and remove extra liquidity from the economy and you get the job done. The key, however, is keeping it down. For that to happen, there must be enough slack in the economy such that when the next recovery begins supply/demand balance doesn’t quickly get out of whack again.
The Great Recession of 2007-2009 created so much slack that it took over a decade to absorb. It only got there after the Fed and Congress fed record amounts of money into the economy. We don’t need that kind of correction.
The two largest factors affecting inflation are wages and shelter costs. Certainly, commodity prices matter as well, but commodity price cycles tend to be both violent and short. For many commodities, supply changes are key. Agricultural commodities, for instance, can be dramatically affected by weather. Oil is often impacted by politics. Wages and shelter costs, however, react more to central bank measures. As a central banker, for instance, you would want to see new homes and apartments being built. You would want them to be affordable as well. At the core of the Great Recession was an explosion of foreclosures. Many potential sellers had seen the equity in their homes disappear. There isn’t much reason to sell if all the proceeds go to the bank. Potential young buyers lacked the equity (or the job) to buy a home, and empty nesters ready to move on couldn’t.
Today is different. The recent surge in home prices means most owners now have equity. Young potential buyers have jobs and funds for a deposit. Higher mortgage rates are crimping demand for now, but when rates moderate, the housing market should be healthy. But for supply/demand balance to be restored, an active new construction market is needed. Pushing housing starts down toward 1 million again would be counterproductive.
As for wages, the unemployment rate is 3.6%, near a 50-year low, and there are still two jobs available for every unemployed American. Because Americans are aging and immigration is extremely low, the labor force participation rate is still well below pre-pandemic levels. The participation rate has been in secular decline for decades. If the Fed’s goal is to anchor inflation expectations near 2%, it isn’t going to happen unless there is some slack in the labor market. Right now, there is none.
I mentioned several dates in July so far, but the big market moving event for July will be earnings season that will commence this week and overwhelm investors for the balance of July. Virtually every quarter companies report earnings that beat analyst expectations. It will happen again this year as Q2 earnings are reported. Both managements and analysts want to lay out forecasts that stand muster, that are beatable. They both leave a little cushion. Therefore, except in the worst of times, earnings beat forecasts by a bit. Of course, that isn’t universally true. In Q1, big names like Netflix, Amazon#, and Wal-Mart all disappointed for different reasons. Each saw a dramatic drop in stock price, but investors expect numbers to be achieved, looking backwards. The Q2 earnings reports will be backward looking. They reflect the past. What investors really want to know is what lies ahead. In robust times, investors want to see a company “beat and raise” meaning it beat estimates for the quarter just ended and raised expectations going forward. Too often, however, in times when growth is either decelerating or uncertain what you get is “beat and lower” or, even worse, “miss and lower” meaning future expectations need to be adjusted downward. That is exactly what happened in April and May, two terrible months for stocks. It is clearly a fear again as we enter Q2 earnings season.
Last quarter, many stocks fell just before earnings, a sign that investors saw a “beat and lower” quarter coming. If they were right and adjusted expectations properly before earnings were reported, then the actual reporting of bad news should have required no further adjustment. But that isn’t what happened in many cases. Expectations, it turned out, were even lower than feared. The stocks declined further.
If one is looking for a bottom, when all the bad news is built-in, one wants to see a company’s stock actually rise after a bad earnings report. That would suggest the worst was already priced in and there was optimism that recovery ahead could lead to higher stock prices. To date this year, we have seen very little of that. Could we start to see it this quarter? That’s a key question. Let me offer just two examples.
We all know the Netflix story. Its Q1 report was dismal. U.S. subscriber growth declined and the company warned of larger subscriber attrition this quarter. It also said that it was considering an ad-supported option at a lower price, and efforts to stop freeloaders from using someone else’s login credentials. Thus, we know Q2 numbers aren’t going to be good. But can Netflix convince investors that it has found the key to resume growth? Can it convince investors that a better second half lies ahead? Or is streaming maturing just as the economy is slowing? Netflix reports next Tuesday after the close. It is already down over 70% from its all-time high and has traded almost flat since early May. It could well be a true indicator for what lies ahead.
Retailers report at the tail end of earnings season. Two biggies are Wal-Mart and Target. Both disappointed big time in Q1. Sales were OK but margins took a beating. Both were stuck with excess inventory. Both announced aggressive steps to resolve the problems. Have they regained control? What’s the outlook going into the holiday sales season? Like Netflix, both stocks were pounded after bad Q1 results. Are they bargains today or value traps?
These are just two examples of many. My instincts are that all the corporate bad news ahead has not been fully priced in. Revenue shortfalls have a devastating impact on short- term earnings results if revenues fall faster than costs, but not all companies will suffer the same fate. There are parts of the economy doing great right now. There are parts of the economy relatively isolated from economic changes. No one is buying less toothpaste quite yet. The market rally of the last two weeks suggest excessive pessimism was built into stock prices, at least for the short-term. Until earnings and expectations line up better, it’s hard to declare that this bear market has seen its bottom.
Today, Richie Sambora, the lead guitarist of Bon Jovi, is 63. One interesting personal piece of trivia is that he was born in the same town as my wife, Perth Amboy, NJ. Giorgio Armani turns 88
James M. Meyer, CFA 610-260-2220